Samsung Q3 16A – Summer cycle

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Margin to be strong while the cycle lasts.

• Samsung has given very solid indications for its Q3 16A results demonstrating that the replacement cycle that it is currently enjoying has yet to be impacted by the Note 7 recall.
• Q3 16A revenues / EBIT are expected to be KRW48tn-KRW50tn / KRW7.7tn – KRW7.9tn which was below consensus revenue forecast of KRW51tn but nicely ahead of EBIT consensus at KRW7.6tn.
• RFM was looking for Q3 16 revenues of KRW54tn / KRW7.1tn.
• I suspect that these numbers do not include any impact from the Note 7 recall which is likely to reported as a one off item and stripped out of the headline numbers.
• Furthermore, the overall impact from this recall is likely to be borne by Samsung SDI, the maker of the faulty battery, in which Samsung Electronics has a 30% stake.
• This will limit Samsung’s financial hit from the recall to around $300m (which will be seen in the associated line of the income statement) but the reputational and brand damage are hard to quantify.
• The good news is that the bad PR surrounding the recall does not appear to have affected the replacement cycle that began in Q1 16A and looks set to continue into early 2017.
• The Galaxy s7 is a good device at a cheaper price that has come at the right time to satisfy replacement demand from owners of the Galaxy s5 and s4.
• The result has been good volumes of this device that has helped handset margins back into the mid-teens which looks to have improved in Q3 16A further given the very strong profitability just reported.
• Consequently, I think that there will be a large and painful one-off hit from the recall followed by a return to business as normal.
• History has shown on several occasions as long as the response is quick and efficient to these sorts of incidents, the damage is not permanent.
• However, I still think that Samsung’s current profitability in handsets is not sustainable and that the long term outlook remains about 11-12%.
• This is because Samsung only makes more money than its Android competitors because it ships more than 2 times the volume of its nearest competitor.
• The only other way to make good margins in handsets is to have an ecosystem which users love and are consequently are prepared to pay for.
• Samsung long ago (January 2014) ceded the ecosystem to Google and this no longer represents an avenue by which it can differentiate its products.
• The net result is that when the Galaxy s7 cycle comes to an end (just as the iPhone 6 cycle did) margins are likely to normalise to around 11-12% going forward.
• This is likely to result in a short period where earnings decline and the share price corrects.
• Samsung is close to my KRW1.8m price target and I would be looking to reduce my position in Samsung ahead of that inevitable correction.